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## Capital Structure

Step-by-Step Guide to Understanding Capital Structure (Debt and Equity Mix)

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## What is Capital Structure?

The Capital Structure is the mixture of debt, preferred stock, and common equity used by a company to fund its operations and purchase assets.

Often referred to as the “capitalization”, the capital structure of a company is determined by management’s discretionary decisions pertaining to how to fund operations and the purchase of fixed assets, or capital expenditures (Capex).

• The capital structure refers to the percentage of common equity, preferred stock, and debt utilized by a corporation to finance its operating activities and acquire fixed assets (PP&E).
• The formula to calculate a company’s capital structure is: Common Equity Weight (%) + Debt Weight (%) + Preferred Stock Weight (%)
• In theory, the optimal capital structure balances the trade-off between the benefits of debt (“interest tax shield”) and the risk of insolvency, i.e. financial distress.
• The weighted average cost of capital (WACC) is minimized, while the implied firm valuation is maximized at the optimal capital structure.

## How Does the Capital Structure Work?

What are the full–form capital structure components, how to analyze capital structure (debt-equity mix), capital structure formula, what factors affect capital structure, how to optimize capital structure (debt–equity ratio), why does the capital structure matter, capital structure calculator, 1. capitalization assumptions, 2. capital structure example (all-equity firm), 3. capital structure example (50/50 debt to equity firm).

The capital structure is the allocation of debt, preferred stock , and common stock by a company used to finance working capital needs and acquire fixed assets (PP&E).

In short, the capital structure is the mixture of debt and equity that firms utilize to finance their near-term and long-term growth strategies.

For most companies that reach a certain size, raising outside capital is frequently a necessity to reach the next stage of growth and to continue their efforts to expand their operations.

Using the proceeds from debt and equity issuances, a company can finance operations, day-to-day working capital needs, capital expenditures ( Capex ), business acquisitions, and more.

Corporations can choose to raise outside capital in the form of either debt or equity.

• Debt → The capital borrowed from creditors as part of a contractual agreement, where the borrower agrees to pay interest and return the original principal on the date of maturity.
• Common Equity → The capital provided from investors in the company in exchange for partial ownership in future earnings and assets of the company.
• Preferred Stock → The capital provided by investors with priority over common equity but lower priority than all debt instruments, with features that blend debt and equity (i.e. “hybrid” securities).

Debt financing is generally perceived as a “cheaper” source of financing than equity, which can be attributed to taxes, among other factors. Unlike dividends , interest payments are tax-deductible, creating a so-called “interest tax shield” as a company’s taxable income (and the amount of taxes due) is lowered.

By opting to raise debt capital, existing shareholders’ control of the firm’s ownership is also protected, unless there is the option for the debt to be converted into equity (i.e. convertible debt).

The lower the percentage of total funding contributed by equity investors, the more credit risk that the lenders must bear – all else being equal.

If the return on investment (ROI) on the debt offsets (and earns more) than the cost of interest and principal repayment, then the company’s decision to risk the shareholders’ equity paid off.

The downside to debt, however, is the required interest expense on loans and bonds, as well as mandatory amortization payments on loans. The latter is far more common for senior debt lenders such as corporate banks, as these risk-averse lenders prioritizing capital preservation are likely to include such provisions in the agreement.

Senior debt is often called senior secured debt, as there can be covenants attached to the loan agreement – albeit restrictive covenants are no longer the norm in the current credit environment.

The formula to determine a company’s capital structure, expressed in percentage form, is as follows.

• Common Equity Weight (%) = Common Equity ÷ Total Capitalization
• Debt Weight (%) = Total Debt ÷ Total Capitalization
• Preferred Stock Weight (%) = Preferred Stock ÷ Total Capitalization

Combined, the resulting percentage contribution per capital source must equal 1.0, or 100%.

Early-stage companies rarely carry any debt on their balance sheet, as finding an interested lender is challenging given their risk profiles.

In contrast, if a borrower is a mature, established company with a track record of historical profitability and low cyclicality, lenders are far more likely to negotiate with them and offer favorable lending terms.

Consequently, a company’s stage in its life cycle, along with its cash flow profile to support the debt on its balance sheet, dictates the most suitable capital structure.

Established, mature companies are able to obtain debt at cheaper pricing rates, contrary to early-stage companies.

The corporate borrower must repay the remaining principal in full at the end of the debt’s maturity – in addition to the interest expense payments during the life of the loan.

The maturity date stated on a lending agreement illustrates how debt represents a finite financing source, unlike common equity, which is perpetual in theory.

If the company fails to repay the principal at maturity, the borrower is now in technical default because it has breached the contractual obligation to repay the lender on time.

Hence, companies with highly leveraged capital structures relative to their free cash flow profile (FCFs) can reasonably handle frequently end up becoming insolvent and filing for bankruptcy.

In such cases, the unsustainable capital structure makes financial restructuring necessary, where the debtor attempts to “right-size” its balance sheet by reducing the debt burden – as negotiated with creditors either out-of-court or in-court.

Most companies seek an “optimal” capital structure, in which the total valuation of the company is maximized while the cost of capital is minimized.

With that said, the objective of most companies is to balance the trade-offs among the benefits of debt (e.g. reduced taxes) and the risk of taking on too much leverage.

The required rate of return, or the cost of capital, is the minimum rate of return a company must earn to meet the hurdle rate of return demanded by the capital providers.

The cost of capital accounts for the weight of each funding source in the company’s total capitalization (and each component’s separate costs).

• Debt ➝ Cost of Debt (kd)
• Common Equity ➝ Cost of Equity (ke)
• Preferred Stock ➝ Cost of Preferred Stock (kp)

The expected future cash flows must be discounted using the proper discount rate – i.e. the cost of capital – for each source of capital.

In effect, the lower the cost of capital (i.e. the “blended” discount rate), the greater the present value (PV) of the firm’s future free cash flows will be.

Leverage ratios can measure a company’s level of reliance on debt to finance assets and determine if the operating cash flows of the company generated by its asset base are sufficient to service interest expense and other financial obligations.

• Debt to Assets Ratio = Total Debt ÷ Total Assets
• Debt to Equity Ratio (D/E) = Total Debt ÷ Total Equity
• Times Interest Earned (TIE) Ratio = EBIT ÷ Fixed Charges
• Fixed Charge Coverage Ratio = (EBIT + Leases) ÷ (Interest Expense Charges + Leases)

If debt begins to comprise a greater proportion of the capital structure, the weighted average cost of capital (WACC) initially declines due to the tax-deductibility of interest (i.e. the “interest tax shield”).

The cost of debt is lower than the cost of equity because of interest expense – i.e. the cost of borrowing debt – is tax-deductible, whereas dividends to shareholders are not.

The WACC continues to decrease until the optimal capital structure is reached, where the WACC is the lowest (and at this point, the firm is at “peak valuation”).

Beyond this threshold, the potential for financial distress offsets the tax benefits of leverage, causing the risk to all company stakeholders to rise.

Thus, debt issuances impact not only the cost of debt but also the cost of equity because the company’s credit risk increases as the debt burden increases – which is particularly concerning for equity holders, who are placed at the bottom of the capital structure.

Common equity represents the lowest priority claim under a liquidation scenario (and are the least likely to recover funds in the case of bankruptcy).

While shareholders are partial owners of the company, on paper, management has no obligation to issue them dividends, so share price appreciation can often be the only source of income.

However, the share price (and capital gain) upside belongs entirely to equity holders, whereas lenders receive only a fixed amount via interest and principal amortization .

We’ll now move to a modeling exercise, which you can access by filling out the form below.

In our illustrative training tutorial in Excel, we’ll compare the same company under two different capital structures.

The company’s total capitalization in both cases is \$1 billion, but the major distinction is where the funding came from.

• Scenario A → All-Equity Firm (No Debt)
• Scenario B → 50/50 Debt-to-Equity Firm

In Scenario A, the company is funded entirely by equity, whereas in the second scenario, the company’s funding is split equally between equity and debt.

We’ll assume the company’s EBIT is \$200 million in both cases, the interest rate on debt is 6%, and the applicable tax rate is 25%.

• Operating Income (EBIT) = \$200 million
• Interest Rate (%) = 6.0%
• Tax Rate (%) = 25.0%

The taxable income is equivalent to EBIT for the all-equity firm, since there is no tax-deductible interest.

Therefore, the tax expense is \$50 million, which results in net income of \$150 million.

Since there are no required payments to debt holders, all the net income could hypothetically be distributed to equity holders as dividends, share buybacks, or kept in retained earnings to reinvest in the company’s operations.

Next, for our company with the 50/50 capital structure, the interest expense comes out to \$30 million, which directly reduces taxable income.

Given the 25% tax rate, the tax incurred is \$7 million less than in the all-equity scenario, representing the interest tax shield .

In the final step, we can see that net income is lower for the company under the capital structure with debt.

Yet, the total distribution of funds is \$8 million higher for the company with debt than the all-equity company because of the additional amount that flowed to debt holders rather than being taxed.

The capital structure should be adjusted to meet a company’s near-term and long-term objectives.

Therefore, the optimal capital structure fluctuates depending on a company’s life-cycle, free cash flow profile (FCF), and prevailing market conditions.

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## Capital Structure

Updated July 12, 2023

## What is Capital Structure?

Capital structure refers to the mix of debt and equity a company uses to finance its business operations and growth. Debt can be raised through bank loans, bond issues, or commercial papers, while equity can come from common stock, preferred stock, or retained earnings.

Usually, a company’s capital structure is expressed as a debt-to-equity ratio or debt-to-capital ratio.

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Some key features of a suitable capital structure for a company are as follows:

• Flexibility: It provides flexibility in terms of financing options so that the finance manager can alter the debt-equity mix based on the needs of the hour. For instance, a growing company might employ higher debt, while a mature company would rely more on equity .
• Profitability: A sound capital structure can be leveraged to improve profitability, translating into higher earnings per share. An optimum capital structure can result in maximum leverage at a minimum cost.
• Solvency: Excessive debt or very high leverage can threaten a company’s solvency and credit rating. The portion of debt in a capital structure should be limited to the extent the company can comfortably service.
• Conservatism: The company should be conservative and ensure it does not exceed its debt capacity. Any debt entails principal repayment and periodic interest payment that depends on future cash flows . If the future cash flows are inadequate for debt servicing, it can result in legal insolvency.
• Control: An increase in leverage means a higher amount of debt that might lead to business owners relinquishing control of the company in the case of inability to repay. Hence, the capital structure should be such that it does not lead to a loss of control in the company.

## Examples of Capital Structure  (With Excel Template)

Below are various examples:

Let us assume that a company plans to invest in an expansion project. The project will be financed 35% through equity infusion, and the remaining funding will occur through bank loans. Determine the debt-to-equity ratio of the project based on the given information:

One calculates the Debt Component using the formula given below:

Debt Component = 1 – Equity Component

• Debt Component = 1 – 35%
• Debt Component = 65%

One calculates the debt-to-equity ratio of the project using the formula given below.

Debt-to-equity Ratio = Debt Component / Equity Component

• Debt-to-equity Ratio = 65% / 35%
• Debt-to-equity Ratio = 1.86x

Hence, the debt-to-equity ratio of the project is 1.86x.

Let us take the example of a company engaged in a trading business. The company has an outstanding cash credit of \$4.5 million, a term loan of \$0.25 million, and a tangible net worth of \$1.5 million. Determine the company’s debt-to-equity ratio based on the given information.

One calculates the Debt using the formula given below:

Debt = Cash Credit + Term Loan

• Debt = \$4.5 million + \$0.25 million
• Debt = \$4.75 million

One calculates the debt-to-equity ratio using the formula given below:

Debt-to-equity Ratio = Debt / Equity

• Debt-to-equity ratio = \$4.75 million / \$1.5 million
• Debt-to-equity ratio = 3.17x

Hence, the company’s debt-to-equity ratio is 3.17x.

## Types of Capital Structure

Companies fund their business operations by either issuing debt or equity. Based on the mix of debt and equity, the capital structure can be broadly classified into three major categories – highly leveraged, lowly leveraged, and optimal.

• Highly leveraged: Companies increase their leverage through increased debt funding to improve profit margins. However, this creates the obligation to pay back lenders, which can worsen the woes of a struggling business.
• Lowly leveraged: Companies issue more equity and give up some ownership. In this way, they can fund business requirements and avoid the liability of paying back lenders.
• Optimal: One achieves optimal capital structure when companies can achieve the perfect mix of debt and equity financing that results in maximum company value at the minimum cost of capital.

The factors that play a key role in determining a company’s capital structure are as follows:

• Cost of capital: This is the cost of capital raised from different fund sources. The interest rate is the cost of capital for debt, while the rate of return is the cost of equity.
• Degree of control: The different types of shareholders and their voting rights influence a company’s capital structure. Typically, equity shareholders enjoy more rights than preference shareholders or debenture shareholders.
• Government policies: The rules and policies introduced by the government impact corporate decisions pertaining to the structure.

It is a crucial factor in determining a company’s overall stability. Some of its important aspects are:

• A company with a sound capital structure typically enjoys a higher valuation in the investor community.
• An optimal structure ensures the efficient use of available funds, avoiding over or undercapitalization issues.
• Companies can use appropriate capital structures to boost profits, resulting in higher shareholder returns.

## Key Takeaways

Some of the key takeaways of the article are:

• A company’s capital structure shows how it finances its business growth.
• A sound structure provides flexibility in financing options and boosts shareholders’ returns by improving profitability.
• The debt-to-equity ratio is a commonly used indicator of capital structure and is useful for determining a company’s borrowing capacity.

Capital structure is a crucial financial aspect for any company, as it determines the proportion of debt or equity in its fund sources. Achieving the optimal capital structure is vital for a company, as it helps maximize shareholders’ capital while minimizing the overall cost of capital. Thus, it is evident that capital structure plays a significant role in a company’s financial stability and growth.

## Recommended Articles

Here are some further related articles for expanding understanding:

• Overcapitalization
• Capitalization Ratio
• Return on Invested Capital
• Structured Note

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• Capital Structure
• Modigliani and Miller Theories
• Degree of Financial Leverage

Capital structure refers to the relative proportion of common stock, preferred stock and debt in a a company's total capital employed. It is normally expressed as a percentage of market value of each component of capital to the sum of the market values of all components of capital.

Capital structure is a statement of the way in which a company's assets are financed. Analysis of capital structure is relevant to understanding the level of risk which a business has. Modigliani and Miller proposed that capital structure is irrelevant when there are no taxes and that 100% debt is the optimal capital structure when there are taxes. However, recent studies suggest that cost of debt falls with increase in the proportion of debt but it leads to an offsetting increase in cost of equity (due to higher distress costs associated with higher debt levels). The optimal structure is where the weighted average cost of capital is lowest and that is anywhere between 100% debt and 100% equity.

## Calculation

 % of Equity = Market Value of Equity Market Value of Equity + Market Value of Debt
 % of Debt = Market Value of Debt Market Value of Equity + Market Value of Debt

If market values are not available, the percentages are calculated based on book values.

Capital structure is also expressed by debt to total assets ratio. Percentage of equity and percentage of debt can also be calculated if we know the financial leverage ratio or debt to equity ratio of the business.

Example 1: Delta Airlines has a recent market capitalization of \$9.79 billion whiles the value of the company i.e. the enterprise value is \$19.74 billion. The percentage of equity in the company's structure is 49.6% (\$9.79 billion/\$19.74 billion). The percentage of debt in the capital is 51.4% (1 minus percentage of equity).

Example 2: Calculation of capital structure from financial leverage ratio : Oceanic Airlines has a financial leverage ratio of 2.5. Find its capital structure.

Financial leverage ratio = Total Assets (A) ÷ Total Equity (E) = 2.5

Total Assets (A) ÷ (Total Assets (A) − Total Liabilities (L)) = 2.5

A = 2.5 × (A − L) A = 2.5 A − 2.5 L 2.5 L = 2.5 A − A 2.5 L = 1.5 A L/A% = 1.5/2.5 = 60%

Percentage of debt in the capital structure of Oceanic Airlines is 60% which gives us a percentage of equity of 40%.

In the same way we can find capital structure as percentage of equity and percentage of debt from debt to equity ratio .

by Obaidullah Jan, ACA, CFA and last modified on May 21, 2019

## Related Topics

• Cost of Equity
• Cost of Debt
• Cost of Capital
• Market Capitalization
• Debt-to-Equity Ratio to Debt Ratio
• Equity Multiplier
• Debt-to-Capital Ratio

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## Capital Structure for Startups

by Sarath | April 15, 2021 | Capital structure , Debt Capital , Equity Capital

You must have heard the term “capital structure” at least once in your life, especially if your family or friends have businesses. For people who are investment analysts, professional investors , or corporate officers, this concept is essential.

This article will tell you about capital structure, the types of capital , and why a sound capital structure is essential for startups .

## All you need to know about Capital Structure

Capital structure is an essential part of a company. It helps the organisation run smoothly and lowers financial burden . Without a strong capital structure, the company is at risk down the road. Having an ideal capital structure is important for startups.

## What is a capital structure?

Startups have to finance their operations in order to attain growth, which can be done by structuring the combination of debt and equity in a way that suits the business. This structure of finance is called the capital structure. They have to choose their approach from all the different available options. They can create equity through common or preferred stock , and/or debt (long & short-term) as loans and bonds . The route they choose will depend on the product they offer and the industry they are in.

There are trade-offs when the business uses debt or equity to finance the operations. Depending on the industry, the management will have to decide the amount to use and balance both to find a point of equilibrium suitable for their company.

## Why is capital structure important for a startup?

Capital structure is an essential factor that contributes to the stability of the company. Startups need to have a good capital structure as this will determine if they will s urvive the initial stages . Other factors that also show this importance are:

• A startup with a good capital structure will draw investors
• The business will be efficient as all the funds and resources will be effectively used, preventing under or overcapitalization .
• As per the startup’s situation, the company will have the flexibility of changing its debt capital .
• Having a proper capital structure minimizes the overall cost of capital while maximizing the shareholder’s capital.
• In the form of higher returns to the shareholders , an effective capital structure will increase their profit .
• If your startup has a sound capital structure, the chances of share prices increasing are high , leading to an overall higher business valuation .

## Factors determining capital structure

There are many factors that affect and influence the capital structure of a startup. This is why it’s necessary to focus on the important factors, including:

• Control – The shareholders type will determine the degree of control. If the startup has more equity shareholders than preference shareholders, they will have control and higher voting rights .
• Government Policies –  It is important as a startup to stay informed on all the policies that the government has set, as it influences your capital structure choice. If there are significant changes in the fiscal and monetary policies, you may have to change your capital structure choice.
• Cost of Capital – Startups raise capital for its operations, and there are costs to do so. These costs that they incur is called the cost of capital . A company should generate enough revenue to negate this cost, and the growth can be sufficiently funded. One way of reducing the cost of capital is by balancing the debt and equity to get an optimal capital structure.
• Trading on Equity – To increase returns, startups borrow new funds using more equity as the source . When the rate of interest the startup pays on debt is less than the rate of return on the total capital or when the rate of interest is higher than the return, they choose to trade on equity.

## Types of Capital Structure

The plan by which a business finances its assets by combining debt and equity optimally is called a capital structure. A business sources funds from various areas to finance its operations, some of them are retained earnings, equity shares, long-term loans, preference shares, and others. Startups have to make a crucial decision and choose the type of source they want to use to raise their capital. Choosing the right type of capital structure will show the strength of the business and also the cost of capital.

The types of capital structures have been explained below.

## Equity Capital

In exchange for common or preferred stock , equity capital is the funds received from investors. Equity is the core of the business, and you can further add debt to this for more funding. The moment an investor invests in this, their investment is at risk. The reason for this is that in a scenario where the firm is liquidated , the company will settle the creditors’ claims before the business pays the shareholders.

Irrespective of the risks, investors put their money into equity for many more reasons. Investing in equity shares gives the investor a degree of control in the business. Through this, they can make sure that the company is efficient, generating sufficient funds , and can pay dividends to the shareholders.

From a valuation perspective, equity capital is considered the total amount given back to the investor after all liabilities are settled in the case of a liquidated company. In the balance sheet, the par value of stocks sold, retained earnings, offsetting amount of the treasury stock, and the additional paid-in capital are components of the equity capital according to an accounting perspective. Equity capital is of two types :

## #1 Contributed Capital

The total amount of money initially invested into the company by the owners and from shareholders as a cost for ownership is known as contributed capital. In other words, it is a part of the total equity recorded by the company. The contributed capital can be in the shareholders’ equity section as a separate account.

Contributed Capital can further be divided into two parts: the regular stock account and the additional paid-in capital account . Here the regular stock account records the par value of a share sold. In the additional paid-in account, all excess payments are recorded. These accounts are created to record the amounts for legal purposes and do not provide any extra information. This is because investors look at the company’s total equity rather than the single amount given in these accounts.

The common entry written down when an investor buys shares from a company is to debit the cash account and credit the contributed capital account . Other transactions also involve contributed capital, such as receiving liability for stock and stock for fixed assets.

## #2 Retained Earnings

Retained earnings is a part of the profit earned that the business keeps separately, for use to grow the business. In other words, it is the profits less dividends and any distributions paid to shareholders . This amount is always adjusted when an entry affects the revenue or expenses in the company accounts. If a company has a considerable amount in the retained earnings account, it means that they are financially strong. The formula to calculate retained earnings (RE) is: retained earnings at the beginning  + net profit/loss – Dividends.

## Debt capital

Debt capital is the type of capital the company raises by taking loans . This loan is also known as growth capital and is paid back at a future date. Debt capital is different from share or equity capital. This is because the lender does not become part owner in the company; they are just creditors. Normally, the creditor is entitled to a fixed interest rate on the loan annually, known as the coupon rate . In some cases, the loan is repaid depending on the company’s monthly revenue; this scenario is similar to revenue-based financing.

Equity holders, unlike debt holders, have rights in the company. But debt ranks higher than equity when it comes to annual repayment. Similarly, if a company is liquidated, the debt is paid off in full before the shareholders get repaid.

Note: In a startups capital structure, these loans are often in the form of convertible notes , like SAFE notes or KISS notes . They have a principal amount, may contain interest terms , and can convert to equity later on .

## What is the optimal capital structure for a startup?

The ideal balance between debt and equity that results in a low WACC ( weighted average cost of capital) is known as the optimal capital structure. The definition does not reflect the same in practice as companies have their own aspect of what they think represents the optimal capital structure. The reason every company has a different perspective also comes down to the industry they are in.

For example , a company in the petroleum industry will not find it suitable to have a high debt ratio as they deal in products with high liquidity.  The ideal ratio should be 1:1 . Whereas for a business in the banking industry, it is ideal to have a high debt ratio as they borrow capital to lend it to customers.  Even though creditors charge financial institutions high interests, banks charge customers high-interest rates to counter it and earn profits.

## Capital structure vs Financial structure

Capital structure is the long-term funds that are sourced by the business. In the balance sheet, it comes under the non-current liabilities and shareholders’ funds . The capital structure includes long-term borrowings, equity capital, debentures, preference shares, retained earnings, and others.

The financial structure is the plan through which company assets are financed . Financial structure is a more extensive concept than capital structure. It represents the entire liabilities and equity side of the balance sheet.

Capital StructureFinancial Structure
Capital structure is the of funds raised by the company.The plan by which the and are financed is the financial structure.
It includes , , , , and others.Financial structure includes the , , , , , and others.
It is shown under and .Financial structure includes the capital structure. It is the entire and .

When you compare the capital structure vs financial structure , the main difference is that the financial structure includes the capital structure.

## Interested to Optimize your Company’s Capital Structure?

Startups have a hard time dealing with the hurdles that come their way during the first couple of years. It is essential that they find their optimal point. Finding the ideal capital structure will depend on various factors such as the industry of the business and the owners’ willingness to give up control of the company. Setting a strong and optimal capital structure allows the company to secure healthy finances.

One tool that can help is Eqvista . It is an advanced equity management tool that helps owners and investors track all financial information about the company’s capital and financial structure. The Eqvista platform also has other features, like our financial modeling in our Waterfall and Round Modeling Analysis, to help you make better financial decisions. Contact us today for more information to get started!

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## Written by True Tamplin, BSc, CEPF®

Reviewed by subject matter experts.

Updated on April 14, 2023

## Fact Checked

Why Trust Finance Strategists?

When deciding on the capital structure of a company, the promoters will have to decide the proportion of capital to be raised by the issue of shares and debentures .

It should be noted that shareholders are paid dividends out of profit , and so they bear the risk involved in carrying out the business activities.

According to Gertenberg, the capital structure (or financial structure) of a company refers to the make-up of its capitalization.

In a broader sense, capital structure includes all long-term funds, including share capital , debentures , bonds , loans, and reserves. Interest is paid on funds raised through loans irrespective of profit or loss.

## Capital Structure: Definition

Funds obtained through shares and loans have their own plus and minus points.

Psychologically speaking, investors who desire a regular source of income typically invest their funds in debentures and loans. By contrast, adventurous investors tend to invest their funds in shares.

Companies, in order to capitalize themselves, seek to derive benefits from the psychology of both shareholders and debenture holders.

The company is said to be high-geared if a large part of its capital is raised through the issue of securities that carry a fixed rate of interest and dividends.

The company is said to be low-geared if it is not required to pay interest and dividends at a fixed rate.

Suppose a company raises \$1,500,000 by issuing shares and \$1,000,000 by issuing debentures. By the above-mentioned definition, the company is said to be low-geared.

In this way, share capital obtained by issuing equity and preference shares , loans raised by issuing debentures, bonds, and loans, and retained earnings constitute the company's capital structure.

## Factors Determining Capital Structure

The following factors should be considered when determining the capital structure of a business enterprise:

1. Nature of the business: If the enterprise is a risky one, it should raise its funds by issuing shares.

For example, manufacturing enterprises, where the degree of risk is considerable, secure capital by issuing of shares.

Trading concerns, which are inherently less risky than manufacturing companies, should obtain their funds by issuing debentures or receiving loans.

A financially sound business should raise its funds by issuing debentures. This is because such enterprises pay dividends at higher rates than the interest rate, and so issuing debentures is the most efficient option.

2. Purpose for which the finance is required: When funds are required to purchase fixed assets (or for unproductive purposes), funds must be raised by issuing of shares.

To meet working capital requirements, funds may also be raised through loans. If the purpose is to generate productive funds, the funds should be raised through borrowings.

3. Trading on equity: Trading on equity means borrowing funds at reasonable rates with the help of share capital.

The policy of trading on equity may be adopted only by those business enterprises satisfying the following requirements:

• The company should be reputed and established (e.g., a blue-chip company)
• The company should earn at rates higher than the interest rate prevailing in the capital market
• The company should have stable and regular earnings, thereby enabling it to pay interest on loans out of its earnings
• The company's cash inflows must be assured
• The company must have sufficient fixed assets to offer in the form of security

4. Intention to retain control of the company: When the existing management wants to retain control over the company, it should obtain funds through loans. Issuing shares will mean granting voting rights to outsiders and losing control.

5. Cost of raising funds: Issuing equity shares is costlier than issuing preference shares and debentures. The company should compare the respective costs and make a suitable decision.

6. Period for which funds are required: Sometimes, funds are needed for the short- or medium-term, in which case borrowing through loans and debentures should be preferred.

When funds are required for a longer period as a permanent investment , equity shares should be issued.

7. Nature and attitude of investors: When investors are adventurous, equity shares should be issued, whereas if investors are cautious, debentures or preference shares should be issued.

When raising funds, the preferences and attitudes of investors should be taken into consideration. Ideally, the company should issue whatever its potential investors will willingly subscribe for.

8. Business cycle: If the business cycle is in a period of depression, investors will not be interested in subscribing to equity shares. In a boom period in the money market, investors are more likely to take risks and, consequently, invest in shares.

9. Statutory provisions: Legal requirements must be honored (e.g., banking companies can issue equity shares only).

## Difference Between Capitalization and Capital Structure

 Capitalization, in a narrow sense, is the sum total of capital raised through shares, debentures, bonds, loans, and retained earnings. Capital structure is the make-up of the company's capitalization (i.e., shares, debentures, bonds, loans, etc.). Capitalization, in a broader sense, refers to the determination of the total needs of capital, its structure, and the arrangement of funds. It includes capital structure in itself. Capital structure, in a broader sense, is an aspect of capitalization. It determines the ratio in which the total capital in the company is contributed by different sources. Capitalization is classified as either over-capitalization or . Capital structure is either high-geared or low-geared. Capitalization is mainly influenced by the internal requirements of the enterprise. Capital structure is mainly influenced by external forces, including market conditions, investor psychology, and government policies.

## How to Determine a Company's Capital Structure FAQs

What is a capital structure.

The capital structure of a company is the make-up of its total capitalization (i.e., shares, Debentures, bonds, loans, etc.) and their respective proportions.

## What are the factors that influence capital structure?

The following factors should be considered when determining the capital structure of a business enterprise: - Nature of the business - Purpose for which the finance is required - Trading on equity - Intention to retain control of the company - Cost of raising funds - Period for which funds are required - Nature and attitude of investors - Business cycle - Statutory provisions - Government taxation policy

## What is capitalization?

Capitalization, in a narrow sense, refers to the sum total of funds raised by a company through its shares, Debentures, bonds, loans, and Retained Earnings.

## What are the factors that determine capitalization?

The following factors should be considered when determining the capitalization of a business enterprise: - Market condition - Investor’s risk-taking attitude - Investor’s preference for different sources of funds - The extent to which funds are required by the business - Business cycle - Government taxation policy

## What are the differences between capitalization and capital structure?

Capitalization, in a broader sense, refers to the total needs of capital, its sources, and arrangements. On the other hand, capital structure refers to the proportion of funds contributed by different sources.

## True Tamplin, BSc, CEPF®

True Tamplin is a published author, public speaker, CEO of UpDigital, and founder of Finance Strategists.

True is a Certified Educator in Personal Finance (CEPF®), author of The Handy Financial Ratios Guide , a member of the Society for Advancing Business Editing and Writing, contributes to his financial education site, Finance Strategists, and has spoken to various financial communities such as the CFA Institute, as well as university students like his Alma mater, Biola University , where he received a bachelor of science in business and data analytics.

To learn more about True, visit his personal website or view his author profiles on Amazon , Nasdaq and Forbes .

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So, you’ve got an idea and you want to start a business —great! Before you do anything else, like seek funding or build out a team, you'll need to know how to write a business plan. This plan will serve as the foundation of your company while also giving investors and future employees a clear idea of your purpose.

Below, Lauren Cobello, Founder and CEO of Leverage with Media PR , gives her best advice on how to make a business plan for your company.

Build your dream business with the help of a high-paying job—browse open jobs on The Muse »

## What is a business plan, and when do you need one?

According to Cobello, a business plan is a document that contains the mission of the business and a brief overview of it, as well as the objectives, strategies, and financial plans of the founder. A business plan comes into play very early on in the process of starting a company—more or less before you do anything else.

“You should start a company with a business plan in mind—especially if you plan to get funding for the company,” Cobello says. “You’re going to need it.”

Whether that funding comes from a loan, an investor, or crowdsourcing, a business plan is imperative to secure the capital, says the U.S. Small Business Administration . Anyone who’s considering giving you money is going to want to review your business plan before doing so. That means before you head into any meeting, make sure you have physical copies of your business plan to share.

## Different types of business plans

The four main types of business plans are:

Let's break down each one:

If you're wondering how to write a business plan for a startup, Cobello has advice for you. Startup business plans are the most common type, she says, and they are a critical tool for new business ventures that want funding. A startup is defined as a company that’s in its first stages of operations, founded by an entrepreneur who has a product or service idea.

Most startups begin with very little money, so they need a strong business plan to convince family, friends, banks, and/or venture capitalists to invest in the new company.

Internal business plans “are for internal use only,” says Cobello. This kind of document is not public-facing, only company-facing, and it contains an outline of the company’s business strategy, financial goals and budgets, and performance data.

Internal business plans aren’t used to secure funding, but rather to set goals and get everyone working there tracking towards them.

As the name implies, strategic business plans are geared more towards strategy and they include an assessment of the current business landscape, notes Jérôme Côté, a Business Advisor at BDC Advisory Services .

Unlike a traditional business plan, Cobello adds, strategic plans include a SWOT analysis (which stands for strengths, weaknesses, opportunities, and threats) and an in-depth action plan for the next six to 12 months. Strategic plans are action-based and take into account the state of the company and the industry in which it exists.

Although a typical business plan falls between 15 to 30 pages, some companies opt for the much shorter One-Page Business Plan. A one-page business plan is a simplified version of the larger business plan, and it focuses on the problem your product or service is solving, the solution (your product), and your business model (how you’ll make money).

A one-page plan is hyper-direct and easy to read, making it an effective tool for businesses of all sizes, at any stage.

## How to create a business plan in 7 steps

Every business plan is different, and the steps you take to complete yours will depend on what type and format you choose. That said, if you need a place to start and appreciate a roadmap, here’s what Cobello recommends:

Before writing your business plan, you’ll want to do a thorough investigation of what’s out there. Who will be the competitors for your product or service? Who is included in the target market? What industry trends are you capitalizing on, or rebuking? You want to figure out where you sit in the market and what your company’s value propositions are. What makes you different—and better?

The purpose of your business plan will determine which kind of plan you choose to create. Are you trying to drum up funding, or get the company employees focused on specific goals? (For the former, you’d want a startup business plan, while an internal plan would satisfy the latter.) Also, consider your audience. An investment firm that sees hundreds of potential business plans a day may prefer to see a one-pager upfront and, if they’re interested, a longer plan later.

## 3. Write your company description

Every business plan needs a company description—aka a summary of the company’s purpose, what they do/offer, and what makes it unique. Company descriptions should be clear and concise, avoiding the use of jargon, Cobello says. Ideally, descriptions should be a few paragraphs at most.

## 4. Explain and show how the company will make money

A business plan should be centered around the company’s goals, and it should clearly explain how the company will generate revenue. To do this, Cobello recommends using actual numbers and details, as opposed to just projections.

For instance, if the company is already making money, show how much and at what cost (e.g. what was the net profit). If it hasn’t generated revenue yet, outline the plan for how it will—including what the product/service will cost to produce and how much it will cost the consumer.

## 5. Outline your marketing strategy

How will you promote the business? Through what channels will you be promoting it? How are you going to reach and appeal to your target market? The more specific and thorough you can be with your plans here, the better, Cobello says.

## 6. Explain how you’ll spend your funding

What will you do with the money you raise? What are the first steps you plan to take? As a founder, you want to instill confidence in your investors and show them that the instant you receive their money, you’ll be taking smart actions that grow the company.

## 7. Include supporting documents

Creating a business plan is in some ways akin to building a legal case, but for your business. “You want to tell a story, and to be as thorough as possible, while keeping your plan succinct, clear, interesting, and visually appealing,” Cobello says. “Supporting documents could include financial projects, a competitive analysis of the market you’re entering into, and even any licenses, patents, or permits you’ve secured.”

A business plan is an individualized document—it’s ultimately up to you what information to include and what story you tell. But above all, Cobello says, your business plan should have a clear focus and goal in mind, because everything else will build off this cornerstone.

“Many people don’t realize how important business plans are for the health of their company,” she says. “Set aside time to make this a priority for your business, and make sure to keep it updated as you grow.”

## Business Plan Example and Template

Learn how to create a business plan

## What is a Business Plan?

A business plan is a document that contains the operational and financial plan of a business, and details how its objectives will be achieved. It serves as a road map for the business and can be used when pitching investors or financial institutions for debt or equity financing .

A business plan should follow a standard format and contain all the important business plan elements. Typically, it should present whatever information an investor or financial institution expects to see before providing financing to a business.

## Contents of a Business Plan

A business plan should be structured in a way that it contains all the important information that investors are looking for. Here are the main sections of a business plan:

## 1. Title Page

The title page captures the legal information of the business, which includes the registered business name, physical address, phone number, email address, date, and the company logo.

## 2. Executive Summary

The executive summary is the most important section because it is the first section that investors and bankers see when they open the business plan. It provides a summary of the entire business plan. It should be written last to ensure that you don’t leave any details out. It must be short and to the point, and it should capture the reader’s attention. The executive summary should not exceed two pages.

## 3. Industry Overview

The industry overview section provides information about the specific industry that the business operates in. Some of the information provided in this section includes major competitors, industry trends, and estimated revenues. It also shows the company’s position in the industry and how it will compete in the market against other major players.

## 4. Market Analysis and Competition

The market analysis section details the target market for the company’s product offerings. This section confirms that the company understands the market and that it has already analyzed the existing market to determine that there is adequate demand to support its proposed business model.

Market analysis includes information about the target market’s demographics , geographical location, consumer behavior, and market needs. The company can present numbers and sources to give an overview of the target market size.

A business can choose to consolidate the market analysis and competition analysis into one section or present them as two separate sections.

## 5. Sales and Marketing Plan

The sales and marketing plan details how the company plans to sell its products to the target market. It attempts to present the business’s unique selling proposition and the channels it will use to sell its goods and services. It details the company’s advertising and promotion activities, pricing strategy, sales and distribution methods, and after-sales support.

## 6. Management Plan

The management plan provides an outline of the company’s legal structure, its management team, and internal and external human resource requirements. It should list the number of employees that will be needed and the remuneration to be paid to each of the employees.

Any external professionals, such as lawyers, valuers, architects, and consultants, that the company will need should also be included. If the company intends to use the business plan to source funding from investors, it should list the members of the executive team, as well as the members of the advisory board.

## 7. Operating Plan

The operating plan provides an overview of the company’s physical requirements, such as office space, machinery, labor, supplies, and inventory . For a business that requires custom warehouses and specialized equipment, the operating plan will be more detailed, as compared to, say, a home-based consulting business. If the business plan is for a manufacturing company, it will include information on raw material requirements and the supply chain.

## 8. Financial Plan

The financial plan is an important section that will often determine whether the business will obtain required financing from financial institutions, investors, or venture capitalists. It should demonstrate that the proposed business is viable and will return enough revenues to be able to meet its financial obligations. Some of the information contained in the financial plan includes a projected income statement , balance sheet, and cash flow.

## 9. Appendices and Exhibits

The appendices and exhibits part is the last section of a business plan. It includes any additional information that banks and investors may be interested in or that adds credibility to the business. Some of the information that may be included in the appendices section includes office/building plans, detailed market research , products/services offering information, marketing brochures, and credit histories of the promoters.

Here is a basic template that any business can use when developing its business plan:

Section 1: Executive Summary

• Present the company’s mission.
• Describe the company’s product and/or service offerings.
• Give a summary of the target market and its demographics.
• Summarize the industry competition and how the company will capture a share of the available market.
• Give a summary of the operational plan, such as inventory, office and labor, and equipment requirements.

Section 2: Industry Overview

• Describe the company’s position in the industry.
• Describe the existing competition and the major players in the industry.
• Provide information about the industry that the business will operate in, estimated revenues, industry trends, government influences, as well as the demographics of the target market.

Section 3: Market Analysis and Competition

• Define your target market, their needs, and their geographical location.
• Describe the size of the market, the units of the company’s products that potential customers may buy, and the market changes that may occur due to overall economic changes.
• Give an overview of the estimated sales volume vis-à-vis what competitors sell.
• Give a plan on how the company plans to combat the existing competition to gain and retain market share.

Section 4: Sales and Marketing Plan

• Describe the products that the company will offer for sale and its unique selling proposition.
• List the different advertising platforms that the business will use to get its message to customers.
• Describe how the business plans to price its products in a way that allows it to make a profit.
• Give details on how the company’s products will be distributed to the target market and the shipping method.

Section 5: Management Plan

• Describe the organizational structure of the company.
• List the owners of the company and their ownership percentages.
• List the key executives, their roles, and remuneration.
• List any internal and external professionals that the company plans to hire, and how they will be compensated.
• Include a list of the members of the advisory board, if available.

Section 6: Operating Plan

• Describe the location of the business, including office and warehouse requirements.
• Describe the labor requirement of the company. Outline the number of staff that the company needs, their roles, skills training needed, and employee tenures (full-time or part-time).
• Describe the manufacturing process, and the time it will take to produce one unit of a product.
• Describe the equipment and machinery requirements, and if the company will lease or purchase equipment and machinery, and the related costs that the company estimates it will incur.
• Provide a list of raw material requirements, how they will be sourced, and the main suppliers that will supply the required inputs.

Section 7: Financial Plan

• Describe the financial projections of the company, by including the projected income statement, projected cash flow statement, and the balance sheet projection.

Section 8: Appendices and Exhibits

• Quotes of building and machinery leases
• Proposed office and warehouse plan
• Market research and a summary of the target market
• Credit information of the owners
• List of product and/or services

• Corporate Structure
• Three Financial Statements
• See all management & strategy resources

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## Making capital structure support strategy

CFOs invariably ask themselves two related questions when managing their balance sheets: should they return excess cash to shareholders or invest it and should they finance new projects by adding debt or drawing on equity? Indeed, achieving the right capital structure the composition of debt and equity that a company uses to finance its operations and strategic investments has long vexed academics and practitioners alike. 1 1. Franco Modigliani and Merton Miller, “The cost of capital, corporate finance, and the theory of investment,” American Economic Review, June 1958, Number 48, pp. 261–97. Some focus on the theoretical tax benefit of debt, since interest expenses are often tax deductible. More recently, executives of public companies have wondered if they, like some private equity firms, should use debt to increase their returns. Meanwhile, many companies are holding substantial amounts of cash and deliberating on what to do with it.

The issue is more nuanced than some pundits suggest. In theory, it may be possible to reduce capital structure to a financial calculation to get the most tax benefits by favoring debt, for example, or to boost earnings per share superficially through share buybacks. The result, however, may not be consistent with a company’s business strategy, particularly if executives add too much debt. 2 2. There is also some potential for too little debt, though the consequences aren’t as dire. In the 1990s, for example, many telecommunications companies financed the acquisition of third-generation (3G) licenses entirely with debt, instead of with equity or some combination of debt and equity, and they found their strategic options constrained when the market fell.

Indeed, the potential harm to a company’s operations and business strategy from a bad capital structure is greater than the potential benefits from tax and financial leverage. Instead of relying on capital structure to create value on its own, companies should try to make it work hand in hand with their business strategy, by striking a balance between the discipline and tax savings that debt can deliver and the greater flexibility of equity. In the end, most industrial companies can create more value by making their operations more efficient than they can with clever financing. 3 3. Richard Dobbs and Werner Rehm, “ The value of share buybacks ,” McKinsey on Finance , Number 16, Summer 2005, pp. 16–20.

## Capital structure’s long-term impact

Capital structure affects a company’s overall value through its impact on operating cash flows and the cost of capital. Since the interest expense on debt is tax deductible in most countries, a company can reduce its after-tax cost of capital by increasing debt relative to equity, thereby directly increasing its intrinsic value. While finance textbooks often show how the tax benefits of debt have a wide-ranging impact on value, they often use too low a discount rate for those benefits. In practice, the impact is much less significant for large investment-grade companies (which have a small relevant range of capital structures). Overall, the value of tax benefits is quite small over the relevant levels of interest coverage (Exhibit 1). For a typical investment-grade company, the change in value over the range of interest coverage is less than 5 percent.

## Tax benefits of debt are often negligible.

The effect of debt on cash flow is less direct but more significant. Carrying some debt increases a company’s intrinsic value because debt imposes discipline; a company must make regular interest and principal payments, so it is less likely to pursue frivolous investments or acquisitions that don’t create value. Having too much debt, however, can reduce a company’s intrinsic value by limiting its flexibility to make value-creating investments of all kinds, including capital expenditures, acquisitions, and, just as important, investments in intangibles such as business building, R&D, and sales and marketing.

Managing capital structure thus becomes a balancing act. In our view, the trade-off a company makes between financial flexibility and fiscal discipline is the most important consideration in determining its capital structure and far outweighs any tax benefits, which are negligible for most large companies unless they have extremely low debt. 4 4. At extremely low levels of debt, companies can create greater value by increasing debt to more typical levels.

Mature companies with stable and predictable cash flows as well as limited investment opportunities should include more debt in their capital structure, since the discipline that debt often brings outweighs the need for flexibility. Companies that face high uncertainty because of vigorous growth or the cyclical nature of their industries should carry less debt, so that they have enough flexibility to take advantage of investment opportunities or to deal with negative events.

Not that a company’s underlying capital structure never creates intrinsic value; sometimes it does. When executives have good reason to believe that a company’s shares are under- or overvalued, for example, they might change the company’s underlying capital structure to create value either by buying back undervalued shares or by using overvalued shares instead of cash to pay for acquisitions. Other examples can be found in cyclical industries, such as commodity chemicals, where investment spending typically follows profits. Companies invest in new manufacturing capacity when their profits are high and they have cash. 5 5. Thomas Augat, Eric Bartels, and Florian Budde, “Multiple choice for the chemical industry,” The McKinsey Quarterly , 2003 Number 3, pp. 126–36. Unfortunately, the chemical industry’s historical pattern has been that all players invest at the same time, which leads to excess capacity when all of the plants come on line simultaneously. Over the cycle, a company could earn substantially more than its competitors if it developed a countercyclical strategic capital structure and maintained less debt than might otherwise be optimal. During bad times, it would then have the ability to make investments when its competitors couldn’t.

## A practical framework for developing capital structure

A company can’t develop its capital structure without understanding its future revenues and investment requirements. Once those prerequisites are in place, it can begin to consider changing its capital structure in ways that support the broader strategy. A systematic approach can pull together steps that many companies already take, along with some more novel ones.

The case of one global consumer product business is illustrative. Growth at this company we’ll call it Consumerco has been modest. Excluding the effect of acquisitions and currency movements, its revenues have grown by about 5 percent a year over the past five years. Acquisitions added a further 7 percent annually, and the operating profit margin has been stable at around 14 percent. Traditionally, Consumerco held little debt: until 2001, its debt to enterprise value was less than 10 percent. In recent years, however, the company increased its debt levels to around 25 percent of its total enterprise value in order to pay for acquisitions. Once they were complete, management had to decide whether to use the company’s cash flows, over the next several years, to restore its previous low levels of debt or to return cash to its shareholders and hold debt stable at the higher level. The company’s decision-making process included the following steps.

## Estimate the financing deficit or surplus.

Set a target credit rating., develop a target debt level over the business cycle., forecasting the financing debt or surplus.

In the example of Consumerco, executives used a simple downside scenario relative to the base case to adjust for the uncertainty of future cash flows. A more sophisticated approach might be useful in some industries such as commodities, where future cash flows could be modeled using stochastic-simulation techniques to estimate the probability of financial distress at the various debt levels illustrated in Exhibit 3.

## Modeling future cash flows with stochastic simulation

The final step in this approach is to determine how the company should move to the target capital structure. This transition involves deciding on the appropriate mix of new borrowing, debt repayment, dividends, share repurchases, and share issuances over the ensuing years.

A company with a surplus of funds, such as Consumerco, would return cash to shareholders either as dividends or share repurchases. Even in the downside scenario, Consumerco will generate €1.7 billion of cash above its target EBITA-to-interest-expense ratio.

For one approach to distributing those funds to shareholders, consider the dividend policy of Consumerco. Given its modest growth and strong cash flow, its dividend payout ratio is currently low. The company could easily raise that ratio to 45 percent of earnings, from 30 percent. Increasing the regular dividend sends the stock market a strong signal that Consumerco thinks it can pay the higher dividend comfortably. The remaining €1.3 billion would then typically be returned to shareholders through share repurchases over the next several years. Because of liquidity issues in the stock market, Consumerco might be able to repurchase only about 1 billion, but it could consider issuing a one-time dividend for the remainder.

The signaling effect 6 6. The market’s perception that a buyback shows how confident management is that the company’s shares are undervalued, for example, or that it doesn’t need the cash to cover future commitments, such as interest payments and capital expenditures. is probably the most important consideration in deciding between dividends and share repurchases. Companies should also consider differences in the taxation of dividends and share buybacks, as well as the fact that shareholders have the option of not participating in a repurchase, since the cash they receive must be reinvested.

While these tax and signaling effects are real, they mainly affect tactical choices about how to move toward a defined long-term target capital structure, which should ultimately support a company’s business strategies by balancing the flexibility of lower debt with the discipline (and tax savings) of higher debt.

Marc Goedhart is an associate principal in McKinsey’s Amsterdam office; Tim Koller is a partner and Werner Rehm is a consultant in the New York office.

This article was first published in the Winter 2006 issue of McKinsey on Finance .

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## An Introduction to Capital Structure

• What It Is and Why It Matters

## Equity Capital

Debt capital.

• Optimal Capital Structure

Cecilie_Arcurs / Getty Images

A company's capital structure refers to the type of money that funds the business and the source of those funds. Capital structure can have an impact on the return a company earns for its shareholders. It can also determine whether a firm survives a recession or depression.

## Key Takeaways

• Capital structure refers to the relationship between debt and equity—the two main forms of capital in a business.
• It is typically measured in terms of the debt-to-equity ratio. A ratio that is greater than 1.0 means the company is financed more by debt than equity.
• Knowing the relationship between these two concepts helps investors assess the risk level of a business.
• Healthy businesses know how to leverage debt within their business model.

## Capital Structure—What It Is and Why It Matters

The term "capital structure" refers to the percentage of capital (money) at work in a business by type. Broadly speaking, it comes in two forms: equity capital and debt capital.

Each type of capital has its pros and cons. A balance is needed to sustain business growth. A large part of wise corporate stewardship and management is the creation of a capital structure that offers the ideal balance of risk and reward for shareholders.

Capital structure is important for Fortune 500 companies. It's also key for small-business owners who are trying to figure out how much of their startup money should come from a bank loan. Too much debt can put the business in danger.

Investors, shareholders, and analysts often look at a business's debt-to-equity ratio to assess whether the business is a sound investment. If this ratio is higher than 1.0, the company is financed by more debt than equity.

Another part of capital structure is working capital, which is the cash a company has on hand. Working capital is the difference between a business's assets and liabilities.

A business with more debt than equity has more liabilities than assets. It is often seen as riskier to invest in, varying by industry.

Many owners fund new businesses with their own money, which could be their savings. Sometimes it comes from family members. A retirement plan may be tapped. One common source of funding for growing companies is equity.

Equity capital refers to money put up by the shareholders, who are then owners. This form of capital comes in two types.

## Contributed Capital

This is money invested in the business in exchange for shares of stock or ownership. Contributed capital can come from shareholders. It may also come from angel investors or venture capitalists (VCs).

Capital from angels and VCs is rarer and harder to access. Angels finance less than 3% of new businesses. VCs fund fewer than 1%. These types of funding force owners to give up a degree of control over their business in return.

## Retained Earnings

This form of capital is profits from past years kept by the company and used to strengthen the balance sheet. It can also fund growth, acquisitions, or expansion.

Equity capital can be the most expensive form of capital a company can use. That's because its "cost" is the return that the firm must earn to attract investment.

An unproven startup, for instance, may need a higher return on equity to convince investors to purchase its stock. By contrast, it's easier for a well-known company such as Procter & Gamble to attract investors. P&G sells household brands that cover a wide range, from toothpaste and shampoo to laundry detergent and beauty products.

The debt capital in a company's capital structure refers to borrowed money that is at work in the business. The cost depends on the health of the company's balance sheet. A firm that is AAA rated can borrow at very low rates. Meanwhile, a risky company with tons of debt may have to pay 15% or more in exchange for debt capital.

There are different varieties of debt capital.

## Loans or Credit Cards

Many businesses start with loans from family or put expenses on a credit card. Many also apply for loans from banks or the Small Business Administration (SBA). Small banks can be good sources of funding for new businesses.

When applying for a loan from a bank or the SBA, you will need to show a business plan. Lenders also want to see projected financials for at least five years and an expense sheet.

## Long-Term Bonds

This is generally considered the safest type of debt because the company has years, even decades, to come up with the principal. In the meantime, it pays only interest.

## Short-Term Commercial Paper

Used by giants such as Walmart and General Electric, this amounts to billions of dollars in 24-hour loans from the capital markets. It can help businesses meet day-to-day working capital requirements such as payroll and utility bills.

## Vendor Financing

In this instance, a company can sell goods before it has to pay the bill to the vendor. That can increase the return on equity quite a bit, yet it costs the company nothing. One secret to Sam Walton's success at Walmart was selling Tide detergent before having to pay the bill to Procter & Gamble. in effect, he was using P&G's money to grow his retail enterprise.

## Policyholder 'Float'

Used by insurance companies, this is money that doesn't belong to the firm. It can be used or earn interest until the company has to pay it out.

## Seeking the Optimal Capital Structure

Many middle-class investors have a goal of being debt-free. When it comes to a business's capital structure, there is more to it.

Many of the most successful companies in the world base their capital structures on one simple consideration—the cost of capital. The so-called DuPont model can offer further insight.

Suppose you can borrow money at 7% for 30 years. The rate of inflation is 3%. You can reinvest that money in core operations at a 15% return. That is a reason to go into debt. It would be wise for your overall capital structure to contain at least 40% to 50% in debt capital, especially if your sales and cost structure are pretty stable.

If you sell an essential product, the debt will be a much lower risk than if you were to operate a theme park in a tourist town at the height of a booming market. This is where managerial talent, experience, and wisdom come into play.

The best managers have a knack for consistently lowering their weighted-average cost of capital by increasing productivity, seeking out higher-return products, leveraging debt wisely, and more.

Ewing Marion Kauffman Foundation. " How Entrepreneurs Access Capital and Get Funded ."

## What Is Capital Structure And Why It Matters In Business

The capital structure shows how an organization financed its operations. Following the balance sheet structure, usually, assets of an organization can be built either by using equity or liability. Equity usually comprises endowments from shareholders and profit reserves. Where instead, liabilities can comprise either current (short-term debt) or non-current (long-term obligations).

refers to the of a company’s , including its and used to finance its operations and growth. It’s a crucial aspect of financial management and impacts a firm’s financial health and risk profile.
in the capital structure represents funds borrowed by the company, typically through loans or bonds. Using debt can provide tax benefits, but it also creates , including interest payments and repayment of principal.
includes funds raised through the sale of company shares, making investors partial owners. Equity financing doesn’t involve debt obligations, but it dilutes ownership and may lead to sharing company profits with shareholders.
The use of debt in the capital structure is known as . It can amplify returns when the return on assets exceeds the cost of debt, but it also increases financial risk because of the fixed interest payments.
Companies aim to establish an that balances the benefits of debt (tax advantages, leverage) with the risks (financial distress, interest costs). The optimal mix varies by industry, size, and business risk.
Maintaining a flexible capital structure allows a company to adapt to changing economic conditions and opportunities. Excessive debt can limit financial flexibility, while too much equity may lead to underutilization of capital.
A company’s capital structure affects its . High debt levels relative to equity can lead to lower credit ratings, impacting borrowing costs and access to capital markets. Maintaining a strong credit rating is crucial for many firms.
The mix of debt and equity influences a company’s . Debt tends to have a lower cost than equity, but increasing debt beyond a certain point can raise the overall cost of capital due to higher interest rates demanded by investors.
The capital structure decisions impact shareholders directly. High leverage can lead to higher returns on equity when profits exceed the cost of debt, but it also raises financial risk. Equity offerings can dilute existing shareholders’ ownership.
The capital structure choices may be influenced by regulatory constraints and industry-specific regulations. For example, banks and financial institutions often have stringent capital requirements imposed by regulatory bodies.
Effective capital structure management is essential for risk management. Companies must balance the need for growth with the ability to handle financial shocks and economic downturns. An appropriate capital structure can mitigate financial distress risk.

## Understanding financial statements

From a financial standpoint, there are three main documents that can be used to represent an organization:

• Balance Sheet : it shows how assets have been acquired by a firm.
• Income Statement : it shows the P/L of a company’s (also called bottom line or profit and loss statement).
• And Cash Flow Statement : it shows cash inflows and outflows of a firm.

For the sake of this guide, we’ll focus primarily on the balance sheet , as this is the document that shows how the company acquired those and it breaks down liability and equity.

## Understanding how assets are built from a financial standpoint

A classic balance sheet is comprised of three main accounts:

On the one side, you have the assets or all the things which, from an accounting standpoint, have been deemed as such. On the other end, those assets will be acquired either through liability (debt or other financing forms) or via equity (primarily capital endowments).

For a more in-depth explanation on how balance sheets work:

## Optimizing the capital structure

In financial theory, there are several tools to optimize the capital structure of a company. One of those tools is called WACC, and it enables us to compute the “optimal” composition of debt and equity for a firm, considering the market value of the same.

Indeed, large institutions, firms, and public companies have used in the 1990s leverage as a form of a capital structure optimization, by perhaps taking on more debt. Indeed, with debt comes lower tax rates, and this, in turn, should improve the market valuation of the company, as debt can be pumped in without requiring capital endowments. This has been at the foundation of financial innovation in the 1990s, with private equity firms taking over public companies with leveraged buyouts .

While this might work in theory, in reality, debt is always risky, and it might create a squeeze effect over the company, as a few bad quarters might create liquidity issues. Therefore, while capital structure optimization makes a lot of sense in theory. That is also hard and risky in practice.

Thus, as a small organization, it might make more sense to rather have cash buffers to plan for bad quarters, rather than taking on debt, which might be cheaper in a given period, yet it might silently raise the company’s overall financial risks.

## Case Studies

• Example : A tech startup, XYZ Tech, is founded by a group of entrepreneurs. Initially, they invest their personal savings (equity) into the company. As the company grows, they seek venture capital funding (equity) to accelerate product development and market expansion. By relying on equity financing, XYZ Tech avoids taking on debt in the early stages when cash flow is uncertain.
• Example : A real estate investor, Jane, wants to purchase a rental property worth \$500,000. She decides to use a combination of equity and debt. Jane invests \$100,000 of her savings (equity) as a down payment and secures a mortgage loan (debt) for the remaining \$400,000. She expects rental income (equity) to cover the mortgage payments while building equity through property appreciation.
• Example : XYZ Corporation, a publicly traded company, plans to expand its operations globally. To raise capital, XYZ issues corporate bonds (debt) with a face value of \$1 billion. Additionally, the company offers new shares (equity) to investors through a secondary stock offering. The proceeds from the bond issuance and equity offering are used to fund the expansion.
• Example : A private equity firm, ABC Partners, identifies a well-established retail company, RetailCo, as a potential target for a leveraged buyout (LBO). ABC Partners acquires RetailCo by financing a significant portion of the purchase price with debt. They aim to improve RetailCo’s operations, increase its profitability (equity), and ultimately sell the company at a higher valuation to cover the debt.
• Example : Tech giant MegaTech Inc. prefers equity financing for its innovative projects. Instead of taking on debt, MegaTech issues stock options (equity) to its employees, aligning their interests with the company’s long-term success. This approach allows MegaTech to invest heavily in research and development without incurring interest expenses.
• Example : A retail chain, SuperMart, plans to open 50 new stores across the country. To finance this expansion, SuperMart secures a loan (debt) from a bank to cover construction and inventory costs. They also use retained earnings (equity) generated from previous profits to contribute to the project’s funding.
• Example : Company ABC, facing economic uncertainties during a recession, decides to prioritize reducing its debt levels. They allocate a portion of their profits (equity) to paying down outstanding loans. While this temporarily reduces shareholder dividends, it enhances the company’s financial stability by lowering interest expenses.
• Example : Comparing Amazon (tech) and a traditional retailer, RetailMart, we find that Amazon relies more on equity financing to fund its expansion and innovation initiatives. In contrast, RetailMart, which has been in business for decades, has a higher proportion of debt in its capital structure due to its stable cash flows and creditworthiness.
• Example : Company XYZ assesses its financial risk by analyzing its capital structure. They recognize that their high debt-to-equity ratio increases the risk of financial distress if their revenue declines unexpectedly. To mitigate this risk, they explore options to refinance debt or issue additional equity.
• Example : Corporation ABC issues bonds to raise capital. These bonds come with debt covenants, including financial ratios and limits on additional borrowing. If ABC violates these covenants by exceeding the specified debt thresholds, the bondholders have the right to demand immediate repayment, creating financial pressure.
• Example : Company XYZ plans to acquire Competitor Corp. As part of the acquisition, they assess both companies’ capital structures. XYZ decides to refinance Competitor Corp.’s existing debt with a lower-interest loan (debt restructuring) and also issues new shares (equity) to fund the acquisition.
• Example : Utility Company A operates in the energy sector, characterized by stable cash flows. To finance infrastructure projects, they issue long-term bonds (debt) at favorable interest rates. In contrast, Tech Startup B relies on equity financing to fund research and development for its groundbreaking technology products.

## Key takeaways

• The capital structure indicates how a firm uses leverage or equity to build its assets and finance its operations.
• Capital structuring is used by larger organizations to optimize the mix between debt and equity, as in some cases debt might be less expensive, and a company can finance its growth without diluting its equity and gain a sort of fiscal advantage from that.
• At the same time, debt and too much leverage can put substantial short-term risk to the organization. A few bad quarters might create liquidy issues that might also end up in bankruptcy.
• That is why for small organizations its important to minimize the amount of debt carried out and enable cash buffers.

## Key Highlights

• Capital Structure: It represents how an organization finances its operations, using a combination of equity and liabilities (short-term and long-term debt).
• Financial Statements: Essential documents used to assess various aspects of a business, including profitability ( income statement), asset sourcing ( balance sheet ), and cash flows ( cash flow statement).
• Balance Sheet: Shows how assets are acquired by a firm, comprising three main accounts: assets, liabilities, and equity.
• Assets : Represent all the things deemed valuable from an accounting standpoint.
• Liability : Includes debt and other financing forms used to acquire assets.
• Equity : Comprises capital endowments and profit reserves used to acquire assets.
• Optimizing the Capital Structure: Financial theory uses tools like WACC to find the “optimal” mix of debt and equity for a firm considering market value .
• WACC (Weighted Average Cost of Capital): It assesses the cost of capital by considering the weight of equity and debt.
• Capital Structure Optimization: Larger organizations may use leverage to optimize their capital structure, taking on more debt for tax advantages and improved market valuation.
• Risks of Debt: While debt can be cheaper, it is also risky and can create liquidity issues for a company, making capital structure optimization challenging and risky in practice.

## Connected Financial Concepts

Circle of Competence

What is a Moat

Buffet Indicator

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Micro-Investing

Meme Investing

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Profit vs. Cash Flow

Double-Entry

• Balance Sheet

• Income Statement

• Cash Flow Statement

Capital Structure

Capital Expenditure

• Financial Statements

Financial Modeling

Financial Ratio

Financial Option

• Accounting Equation
• Financial Statements In A Nutshell
• Cash Flow Statement In A Nutshell
• How To Read A Balance Sheet Like An Expert
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## 17.1 The Concept of Capital Structure

By the end of this section, you will be able to:

• Distinguish between the two major sources of capital appearing on a balance sheet.
• Explain why there is a cost of capital.
• Calculate the weights in a company’s capital structure.

## The Basic Balance Sheet

In order to produce and sell its products or services, a company needs assets. If a firm will produce shirts, for example, it will need equipment such as sewing machines, cutting boards, irons, and a building in which to store its equipment. The company will also need some raw materials such as fabric, buttons, and thread. These items the company needs to conduct its operations are assets . They appear on the left-hand side of the balance sheet.

The company has to pay for these assets. The sources of the money the company uses to pay for these assets appear on the right-hand side of the balance sheet. The company’s sources of financing represent its capital . There are two broad types of capital: debt (or borrowing) and equity (or ownership).

Figure 17.2 is a representation of a basic balance sheet. Remember that the two sides of the balance sheet must be Assets = Liabilities  +   Equity Assets = Liabilities  +   Equity . Companies typically finance their assets through equity (selling ownership shares to stockholders) and debt (borrowing money from lenders). The debt that a firm uses is often referred to as financial leverage . The relative proportions of debt and equity that a firm uses in financing its assets is referred to as its capital structure .

## Attracting Capital

When a company raises money from investors, those investors forgo the opportunity to invest that money elsewhere. In economics terms, there is an opportunity cost to those who buy a company’s bonds or stock.

Suppose, for example, that you have \$5,000, and you purchase Tesla stock. You could have purchased Apple stock or Disney stock instead. There were many other options, but once you chose Tesla stock, you no longer had the money available for the other options. You would only purchase Tesla stock if you thought that you would receive a return as large as you would have for the same level of risk on the other investments.

From Tesla’s perspective, this means that the company can only attract your capital if it offers an expected return high enough for you to choose it as the company that will use your money. Providing a return equal to what potential investors could expect to earn elsewhere for a similar risk is the cost a company bears in exchange for obtaining funds from investors. Just as a firm must consider the costs of electricity, raw materials, and wages when it calculates the costs of doing business, it must also consider the cost of attracting capital so that it can purchase its assets.

## Weights in the Capital Structure

Most companies have multiple sources of capital. The firm’s overall cost of capital is a weighted average of its debt and equity costs of capital. The average of a firm’s debt and equity costs of capital, weighted by the fractions of the firm’s value that correspond to debt and equity, is known as the weighted average cost of capital (WACC) .

The weights in the WACC are the proportions of debt and equity used in the firm’s capital structure. If, for example, a company is financed 25% by debt and 75% by equity, the weights in the WACC would be 25% on the debt cost of capital and 75% on the equity cost of capital. The balance sheet of the company would look like Figure 17.3 .

These weights can be derived from the right-hand side of a market-value-based balance sheet. Recall that accounting-based book values listed on traditional financial statements reflect historical costs. The market-value balance sheet is similar to the accounting balance sheet, but all values are current market values.

Just as the accounting balance sheet must balance, the market-value balance sheet must balance:

This equation reminds us that the values of a company’s debt and equity flow from the market value of the company’s assets.

Let’s look at an example of how a company would calculate the weights in its capital structure. Bluebonnet Industries has debt with a book (face) value of \$5 million and equity with a book value of \$3 million. Bluebonnet’s debt is trading at 97% of its face value. It has one million shares of stock, which are trading for \$15 per share.

First, the market values of the company’s debt and equity must be determined. Bluebonnet’s debt is trading at a discount; its market value is 0.97 × \$ 5,000,000 = \$ 4,850,000 0.97 × \$ 5,000,000 = \$ 4,850,000 . The market value of Bluebonnet’s equity equals Number of Shares   ×   Price per Share   =   1,000,000   ×   \$ 15   =   \$ 15,000,000 Number of Shares   ×   Price per Share   =   1,000,000   ×   \$ 15   =   \$ 15,000,000 . Thus, the total market value of the company’s capital is \$ 4,850,000   +   \$ 15,000,000   =   \$ 19,850,000 \$ 4,850,000   +   \$ 15,000,000   =   \$ 19,850,000 . The weight of debt in Bluebonnet’s capital structure is \$ 4 , 850 , 000 \$ 19 , 850 , 000 = 24.4% \$ 4 , 850 , 000 \$ 19 , 850 , 000 = 24.4% . The weight of equity in its capital structure is \$ 15 , 000 , 000 \$ 19 , 850 , 000 = 75.6% \$ 15 , 000 , 000 \$ 19 , 850 , 000 = 75.6% .

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Any aspiring entrepreneur researching how to start a business will likely be advised to write a business plan. But few resources provide business plan examples to really guide you through writing one of your own.

## 7 business plan examples: section by section

• Company description.  A more in-depth and detailed description of your business and why it exists.
• Market analysis.  Research-based information about the industry and your target market.
• Products and services.  What you plan to offer in exchange for money.
• Marketing plan.   The promotional strategy to introduce your business to the world and drive sales.
• Logistics and operations plan.  Everything that happens in the background to make your business function properly.
• Financial plan.  A breakdown of your numbers to show what you need to get started as well as to prove viability of profitability.
• Executive summary

Your  executive summary  is a page that gives a high-level overview of the rest of your business plan. It’s easiest to save this section for last.

In this  free business plan template , the executive summary is four paragraphs and takes a little over half a page:

• Company description

You might repurpose your company description elsewhere, like on your About page, social media profile pages, or other properties that require a boilerplate description of your small business.

Soap brand ORRIS  has a blurb on its About page that could easily be repurposed for the company description section of its business plan.

You can also go more in-depth with your company overview and include the following sections, like in the example for Paw Print Post:

• Business structure.  This section outlines how you  registered your business —as an  LLC , sole proprietorship, corporation, or other  business type . “Paw Print Post will operate as a sole proprietorship run by the owner, Jane Matthews.”
• Nature of the business.  “Paw Print Post sells unique, one-of-a-kind digitally printed cards that are customized with a pet’s unique paw prints.”
• Industry.  “Paw Print Post operates primarily in the pet industry and sells goods that could also be categorized as part of the greeting card industry.”
• Background information.  “Jane Matthews, the founder of Paw Print Post, has a long history in the pet industry and working with animals, and was recently trained as a graphic designer. She’s combining those two loves to capture a niche in the market: unique greeting cards customized with a pet’s paw prints, without needing to resort to the traditional (and messy) options of casting your pet’s prints in plaster or using pet-safe ink to have them stamp their ‘signature.’”
• Business objectives.  “Jane will have Paw Print Post ready to launch at the Big Important Pet Expo in Toronto to get the word out among industry players and consumers alike. After two years in business, Jane aims to drive \$150,000 in annual revenue from the sale of Paw Print Post’s signature greeting cards and have expanded into two new product categories.”
• Team.  “Jane Matthews is the sole full-time employee of Paw Print Post but hires contractors as needed to support her workflow and fill gaps in her skill set. Notably, Paw Print Post has a standing contract for five hours a week of virtual assistant support with Virtual Assistants Pro.”

Your  mission statement  may also make an appearance here.  Passionfruit  shares its mission statement on its company website, and it would also work well in its example business plan.

• Market analysis

The market analysis consists of research about supply and demand, your target demographics, industry trends, and the competitive landscape. You might run a SWOT analysis and include that in your business plan.

Here’s an example  SWOT analysis  for an online tailored-shirt business:

You’ll also want to do a  competitive analysis  as part of the market research component of your business plan. This will tell you who you’re up against and give you ideas on how to differentiate your brand. A broad competitive analysis might include:

• Target customers
• Unique value add  or what sets their products apart
• Sales pitch
• Price points  for products
• Shipping  policy
• Products and services

This section of your business plan describes your offerings—which products and services do you sell to your customers? Here’s an example for Paw Print Post:

• Marketing plan

The Paw Print Post focuses on four Ps: price, product, promotion, and place. However, you can take a different approach with your marketing plan. Maybe you can pull from your existing  marketing strategy , or maybe you break it down by the different marketing channels. Whatever approach you take, your marketing plan should describe how you intend to promote your business and offerings to potential customers.

• Logistics and operations plan

The Paw Print Post example considered suppliers, production, facilities, equipment, shipping and fulfillment, and inventory.

## Financial plan

The financial plan provides a breakdown of sales, revenue, profit, expenses, and other relevant financial metrics related to funding and profiting from your business.

Ecommerce brand  Nature’s Candy’s financial plan  breaks down predicted revenue, expenses, and net profit in graphs.

It then dives deeper into the financials to include:

• Funding needs
• Projected profit-and-loss statement
• Projected balance sheet
• Projected cash-flow statement

You can use this financial plan spreadsheet to build your own financial statements, including income statement, balance sheet, and cash-flow statement.

## Types of business plans, and what to include for each

A one-page business plan is meant to be high level and easy to understand at a glance. You’ll want to include all of the sections, but make sure they’re truncated and summarized:

• Executive summary: truncated
• Market analysis: summarized
• Products and services: summarized
• Marketing plan: summarized
• Logistics and operations plan: summarized
• Financials: summarized

A startup business plan is for a new business. Typically, these plans are developed and shared to secure  outside funding . As such, there’s a bigger focus on the financials, as well as on other sections that determine viability of your business idea—market research, for example.

• Market analysis: in-depth
• Financials: in-depth

Your internal business plan is meant to keep your team on the same page and aligned toward the same goal.

A strategic, or growth, business plan is a bigger picture, more-long-term look at your business. As such, the forecasts tend to look further into the future, and growth and revenue goals may be higher. Essentially, you want to use all the sections you would in a normal business plan and build upon each.

• Market analysis: comprehensive outlook
• Products and services: for launch and expansion
• Marketing plan: comprehensive outlook
• Logistics and operations plan: comprehensive outlook
• Financials: comprehensive outlook

## Feasibility

Your feasibility business plan is sort of a pre-business plan—many refer to it as simply a feasibility study. This plan essentially lays the groundwork and validates that it’s worth the effort to make a full business plan for your idea. As such, it’s mostly centered around research.

## Set yourself up for success as a business owner

• How to Start a Dropshipping Business- A Complete Playbook for 2024
• The 13 Best Dropshipping Suppliers in 2024
• How To Source Products To Sell Online
• 25+ Ideas for Online Businesses To Start Now (2024)
• The Ultimate Guide To Dropshipping (2024)
• How to Build a Business Website for Beginners
• 7 Inspiring Marketing Plan Examples (and How You Can Implement Them)
• 10 Ways to Write Product Descriptions That Persuade (2024)
• Get Guidance- 6 Business Plan Software to Help Write Your Future

How do i write a simple business plan, what is the best format to write a business plan, what are the 4 key elements of a business plan.

• Executive summary: A concise overview of the company's mission, goals, target audience, and financial objectives.
• Business description: A description of the company's purpose, operations, products and services, target markets, and competitive landscape.
• Market analysis: An analysis of the industry, market trends, potential customers, and competitors.
• Financial plan: A detailed description of the company's financial forecasts and strategies.

## What are the 3 main points of a business plan?

• Concept: Your concept should explain the purpose of your business and provide an overall summary of what you intend to accomplish.
• Cashflow: Your cash flow section should include information about your expected cash inflows and outflows, such as capital investments, operating costs, and revenue projections.

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• Fundamental Analysis

## Capital Structure Theory: What It Is in Financial Management

Gordon Scott has been an active investor and technical analyst or 20+ years. He is a Chartered Market Technician (CMT).

In financial management, capital structure theory refers to a systematic approach to financing business activities through a combination of equities and liabilities.

There are several competing capital structure theories, each of which explores the relationship between debt financing , equity financing , and the market value of the firm slightly differently.

## Net Income Approach to Capital Structure Theory

David Durand first suggested this approach in 1952, and he was a proponent of financial leverage. He postulated that a change in financial leverage results in a change in capital costs . In other words, if a company takes on more debt to leverage investments, its capital structure increases in size and the  weighted average cost of capital (WACC) decreases, which results in higher firm value.

It postulates that the market analyzes a whole firm, and any discount has no relation to the debt-to-equity ratio . If tax information is provided, it states that WACC decreases with an increase in debt financing, and the value of a firm will increase.

In this approach to Capital Structure Theory, the cost of capital is a function of the capital structure. It's important to remember, however, that this approach assumes an optimal capital structure . Optimal capital structure implies that at a certain ratio of debt and equity, the cost of capital is at a minimum, and the value of the firm is at a maximum.

## Modigliani and Miller's Approach

The M&M theorem is a capital structure approach named after Franco Modigliani and Merton Miller in the 1950s. Modigliani and Miller were two professors who studied capital structure theory and collaborated to develop the capital-structure irrelevance proposition. This proposition states that in perfect markets, the capital structure a company uses doesn't matter because the market value of a firm is determined by its earning power and the risk of its underlying assets. According to Modigliani and Miller, value is independent of the method of financing used and a company's investments. The M&M theorem made two propositions:

• Proposition I : This proposition says that the capital structure is irrelevant to the value of a firm. The value of two identical firms would remain the same, and value would not be affected by choice of finance adopted to finance the assets. The value of a firm is dependent on the expected future earnings. It is when there are no taxes.
• Proposition II : This proposition says that the financial leverage boosts the value of a firm and reduces WACC. It is when tax information is available.

## Pecking Order Theory

The pecking order theory focuses on asymmetrical information costs. This approach assumes that companies prioritize their financing strategy based on the path of least resistance. Internal financing is the first preferred method, followed by debt and external equity financing as a last resort.

To summarize, it is essential for finance professionals to know about the capital structure. Accurate analysis of capital structure can help a company by optimizing the cost of capital and hence improving profitability.

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• How to Start a Business

## Learn the Common Types of Business Structures

• April 26, 2022 June 24, 2024

A critical decision for all new business owners is selecting the legal business structure that is best for them. Choosing the correct structure ensures better protection of their personal assets, a stronger chance of obtaining business loans, and the best possible tax situation.

Main types of business structures include sole proprietorship, partnership, corporation ( C corporation or S corporation ), or limited liability company (LLC).

## Choosing the Right Business Structure

Understanding the legal and tax implications of each structure is critical to making an informed choice. One of the biggest decisions business owners must make is determining whether to choose a structure that involves incorporating their business.

When selecting how to structure their business, owners need to consider:

• Types of liability. What kind of damage might your business be responsible for if things go wrong? A baker, for example, may be held liable for spoiled food that makes people ill.
• Management and operation needs. Who owns the business? Who else can make decisions? Think of how many people are involved and how much control they have over the business.
• Raising capital. Where is the funding coming from to start the business?
• Taxes. Personal or corporate—which is best? Taxes are often the most complicated matter to navigate for new business owners.

## Sole Proprietorship

In a sole proprietorship , the individual who founded the business remains the sole owner. They retain complete control over every aspect of the business. This is the easiest business structure for new or small business owners, as it is cost-effective and there are no other stakeholders to consider when making decisions.

However, a sole proprietorship offers no legal separation between business and personal assets or responsibilities. The owner assumes all risk when it comes to taxes and other legal liabilities, as sole proprietorships are not incorporated. In a worst-case scenario, a business owner could find their house or car up for seizure for debts or because of legal action against the business.

## Partnership

Like a sole proprietorship, a partnership is also an unincorporated business. In this situation, there are two or more owners. Each partner contributes money, labor, skills, or property to the business according to their strengths.

Business owners may select a partner to combine resources and skills, trading off full control over decisions they would have as a sole proprietor. Personal assets of the partners are not protected and may be used as collateral in court.

## Limited Liability Company

Both sole proprietorships and partnerships can file additional documentation to become a Limited Liability Company (LLC) or a Limited Liability Partnership (LLP), which offers some level of legal protection. An LLC combines the pass-through taxation of a sole proprietorship or a partnership with the limited legal liability of a corporation. In both cases, the business owner would pay self-employment taxes instead of corporate taxes.

The biggest appeal of establishing an LLC is the balance between the control and simplicity of sole proprietorships or partnerships and the legal protection of a separate business entity. Personal assets such as cars, homes, and personal savings accounts cannot become part of a business bankruptcy or a lawsuit.

The exact rules and regulations that govern LLCs vary by state.

## C Corporation

When people hear “corporation,” they are thinking about C corporations. This legal business structure offers the most protection to business owners, but it is also the most expensive and intensive structure to establish and maintain.

Taxes and paperwork are far more complicated than they are in the previously discussed options. A corporation reports all profits for tax purposes, often paying twice: once on profits and once when shareholders receive dividend payments.

As far as raising capital, corporations are at an advantage. Banks are far more likely to approve substantial loans and the business can sell shares.

## S Corporation

Though similar to a C corporation, S corporations have a significant difference: Profits and losses can pass through personal bank accounts and be reported on individual income taxes. This avoids the double taxation inherent in the C corporation structure.

This is understandably appealing, so why don’t more business owners select the S corporation structure over the C corporation structure? The IRS has stringent guidelines that businesses must meet to be granted S corporation status. To qualify, the business:

• Must be owned strictly by U.S. citizens.
• Cannot have partnerships, corporations, or non-resident aliens as shareholders.
• May have no more than 100 shareholders.
• May have only one class of stock.

## B Corporation

B corporations effectively function the same as C corporations. The difference is that they also aim to provide value and benefits to the public, not just to shareholders. However, a B corporation is not an option in every state, and the exact requirements vary where this type of business structure is an option.

## Nonprofit Corporation

Businesses that focus on the public good—such as education, charity, and scientific organizations—are granted a tax-exempt status by the IRS. Nonprofits must maintain detailed records and file additional paperwork to maintain their classification.

## What Business Structure Is Best for You?

Lynnise E. Pantin , Pritzker Pucker Family Clinical Professor of Transactional Law and founding director of the Columbia Law School Entrepreneurship and Community Development Clinic, notes that there is no right or wrong choice when it comes to business structure.  “It’s really about looking at the factors,” she says. “What are you thinking about liability, what are you thinking about how the business structure affects the management and operations of the business, how do you interpret how you expect to raise capital, and what are the tax consequences of the choices you make?”

If you are struggling to answer these questions, know that you are not alone. Many new business owners go through the same difficulty.

We invite you to learn how to select the best business structure with the guidance of an expert. Join Professor Pantin and other business owners in the non-credit certificate course: A Legal Toolkit for Starting and Scaling Your Business .

## More From Forbes

5 ways to raise capital as a small business.

Proud family man, global traveler and creator of award-winning agencies Weberous and Generate Culture serving clients worldwide @rafaelromis

When first starting out, you probably relied on bootstrapping or loans from friends and family. Now, your business is positioned to scale, but there’s one problem: You need more capital. If you’re looking for different ways to raise more capital for your small business, you’re not alone. In 2023, small businesses in the U.S. borrowed \$52.4 billion from the Small Business Administration (SBA). That’s more than several countries’ GDPs and doesn't even account for other lenders' loans.

We've worked with over 300 small businesses, and I can tell you firsthand that bootstrapping does work, but it's much slower, and often speed to market is the key to success. That's why funding is so important.

What's interesting is that a lot of business owners don't consider all of the funding options they have available. Here are some you should think about:

## Best High-Yield Savings Accounts Of 2024

Best 5% interest savings accounts of 2024, government grants.

In my opinion, one of the most underrated funding opportunities for small businesses is government grants. Unlike most loan options, government grants are awarded by the U.S. government and do not have to be paid back. However, they involve strict criteria for applicants, and it can be quite an extensive application process.

Even though it can take some time and a lot of paperwork, the payoff can be worth it if your application is accepted. The two main types of government grants are federal small-business grants and state or regional small-business grants.

Another lesser-known option is corporate small-business grants. A growing number of large companies with a philanthropic mission offer small-business grants to smaller companies that align with their vision and values. While most corporate grants are awarded to nonprofit organizations, there are some available to for-profit businesses.

SBA loans typically offer the best rates and terms for small-business loans. To qualify, you typically need to meet certain criteria, but if you don’t, there are many other lenders you can reach out to.

In recent years, as technology has advanced, digital lenders have grown as an alternative to traditional banks. The entire process is very quick, can be done completely online, and generally has a higher approval rate than traditional banks. The caveat is that they typically have higher APRs and more expensive rates overall, but it may be worth the trade-off.

## Crowdfunding

One of the most unique funding opportunities of the 21st century is crowdfunding. There are thousands of incredible stories of businesses that rose to the top through a successful crowdfunding campaign. For example, a few years ago, one of our clients raised \$3-plus million on the popular crowdfunding platform Kickstarter for their innovative luggage. With the right product and the right pitch, you could be the next one.

Crowdfunding is a unique way for you to not only raise capital to reach your business goals but also connect with like-minded people and potential customers. It’s a funding and marketing opportunity: With the right crowdfunding campaign, you could end up with thousands of new customers and millions in capital, all while reaching your growth goals.

## Angel Investors

Another alternative to a traditional business loan is securing funding from an angel investor, an accredited business-savvy individual who invests their own money into small businesses.

Most angel investors operate alone, while some work together to form a fund, and they can be a great source of capital for your small business. They’re more likely to have a higher risk tolerance than traditional lenders, which can make all the difference when dealing with startups. The key here is to put together a great business plan and a solid pitch. This is so important that there are agencies specializing in just that.

## Venture Capitalists

Venture capitalists (VCs) are similar to angel investors in that they are business-minded individuals with funding, looking to invest in small businesses.

However, venture capitalists typically operate as firms rather than individuals and often use other people’s money. These funds have far greater investment power than angel investors, as they invest with pooled money. This means they’re more risk-averse and usually want to invest in more mature and proven companies. VCs may also want more of a say in managing day-to-day operations in your business.

## Bonus Tips To Remember When Raising Capital

If you’ve only ever raised your own money for your business, then trying to figure out how to raise outside funds for the first time can be intimidating. Here are a few tips to remember to increase your odds of securing funding for your business:

• Create a strong business plan. This includes everything from your financial figures to your operation strategy, risk management and exit strategy.

• Focus on investors in your niche. Investors typically work within a niche just like you. Find the investors in your niche and pitch to them.

• Understand what each investor brings to the table. Some investors just loan money, while others help you operate and scale. Know the difference before you accept funding.

And possibly the most important tip is to be persistent. Many, if not most investors won’t respond to you at all. Don’t take it personally. Keep reaching out to investors even if you don’t get any bites. It may sound far-fetched, but the time and effort spent reaching out may literally be the deciding factor for the overall success of your business.

Forbes Agency Council is an invitation-only community for executives in successful public relations, media strategy, creative and advertising agencies. Do I qualify?

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#### IMAGES

1. Capital Structure: Definition, Components, Factors, Importance

2. Capital Structure: Debt-Equity Ratio Calculation Analysis

3. What is capital structure

4. What Is Capital Structure And Why It Matters In Business

5. Financial Structure, Capital Structure (Capitalization) and Leverage

6. Capital structure planning format

1. Capital Structure

Capital structure refers to the composition of a company's sources of funds, a combination of owner's capital (equity) and loan (debt) from outsiders. One may use it to finance overall business operations and investment activities. The types of capital structure are equity share capital, debt, preference share capital, and vendor finance.

2. Capital Structure Definition, Types, Importance, and Examples

Capital Structure: The capital structure is how a firm finances its overall operations and growth by using different sources of funds. Debt comes in the form of bond issues or long-term notes ...

3. Capital Structure: Definition & Examples

Learn what capital structure is and how it affects a company's value, risk and cost of capital. See examples of different types of capital structure, such as equity, debt and vendor financing.

4. Analyzing a Company's Capital Structure

Capital structure is a type of funding that supports a company's growth and related assets. Sometimes it's referred to as capitalization structure or simply capitalization. Expressed as a formula ...

5. Capital Structure

Capital structure refers to the amount of debt and/or equity employed by a firm to fund its operations and finance its assets. A firm's capital structure is typically expressed as a debt-to-equity or debt-to-capital ratio. Debt and equity capital are used to fund a business's operations, capital expenditures, acquisitions, and other ...

6. Capital Structure

The capital structure refers to the percentage of common equity, preferred stock, and debt utilized by a corporation to finance its operating activities and acquire fixed assets (PP&E). The formula to calculate a company's capital structure is: Common Equity Weight (%) + Debt Weight (%) + Preferred Stock Weight (%) In theory, the optimal ...

7. Capital: Definition, How It's Used, Structure, and Types in Business

Capital refers to financial assets or the financial value of assets, such as funds held in deposit accounts, as well as the tangible machinery and production equipment used in environments such as ...

8. Capital Structure

Factors. The factors that play a key role in determining a company's capital structure are as follows: Cost of capital: This is the cost of capital raised from different fund sources. The interest rate is the cost of capital for debt, while the rate of return is the cost of equity. Degree of control: The different types of shareholders and ...

9. Capital Structure

Examples. Example 1: Delta Airlines has a recent market capitalization of \$9.79 billion whiles the value of the company i.e. the enterprise value is \$19.74 billion. The percentage of equity in the company's structure is 49.6% (\$9.79 billion/\$19.74 billion). The percentage of debt in the capital is 51.4% (1 minus percentage of equity).

10. What Is Capital Structure? Types, Impact, Factors, and Formula

Capital structure refers to the mix of debt and equity capital that a company uses to finance business operations, capital expenditures, acquisitions, and assets. You can understand a firm's capital structure by looking at its debt-to-equity or debt-to-capital ratio. Businesses can raise funds with shareholders' equity or ownership shares ...

11. Capital Structure for Startups

Types of Capital Structure. The plan by which a business finances its assets by combining debt and equity optimally is called a capital structure. A business sources funds from various areas to finance its operations, some of them are retained earnings, equity shares, long-term loans, preference shares, and others. ... For example, a company in ...

12. Determining Company's Capital Structure

The following factors should be considered when determining the capital structure of a business enterprise: 1. Nature of the business: If the enterprise is a risky one, it should raise its funds by issuing shares. For example, manufacturing enterprises, where the degree of risk is considerable, secure capital by issuing of shares.

13. How to Write a Business Plan: Step-by-Step Guide

A one-page business plan is a simplified version of the larger business plan, and it focuses on the problem your product or service is solving, the solution (your product), and your business model (how you'll make money). A one-page plan is hyper-direct and easy to read, making it an effective tool for businesses of all sizes, at any stage ...

14. Capital Structure: What Is It?

Definition & Examples of Capital Structure. By Rosemary Carlson. Updated on September 25, 2020. Photo: krisanapong detraphiphat / Getty Images. Capital structure refers to a business's composition of debt and equity. Learn how it works and why it matters to small business owners.

15. Business Plan Example and Template

Here is a basic template that any business can use when developing its business plan: Section 1: Executive Summary. Present the company's mission. Describe the company's product and/or service offerings. Give a summary of the target market and its demographics.

16. What Is Capital in Business?

A building, equipment, and vehicles are examples of capital assets for tax purposes. Capital Structure of a Business The capital structure of a business is the mix of types of debt (borrowing) and equity (ownership). Business capital is shown on the business's balance sheet. The format for this report shows all the asses of the business in one ...

17. Making capital structure support strategy

Making capital structure support strategy. The issue is more nuanced than some pundits suggest. In theory, it may be possible to reduce capital structure to a financial calculation to get the most tax benefits by favoring debt, for example, or to boost earnings per share superficially through share buybacks.

18. An Introduction to Capital Structure

A company's capital structure refers to the type of money that funds the business and the source of those funds. Capital structure can have an impact on the return a company earns for its shareholders. It can also determine whether a firm survives a recession or depression.

19. What Is Capital Structure And Why It Matters In Business

Capital Structure refers to the composition of a company's capital, including its mix of debt and equity used to finance its operations and growth. It's a crucial aspect of financial management and impacts a firm's financial health and risk profile. Debt Financing. Debt in the capital structure represents funds borrowed by the company ...

20. 17.1 The Concept of Capital Structure

The weights in the WACC are the proportions of debt and equity used in the firm's capital structure. If, for example, a company is financed 25% by debt and 75% by equity, the weights in the WACC would be 25% on the debt cost of capital and 75% on the equity cost of capital. The balance sheet of the company would look like Figure 17.3.

21. PDF Capital Structure: Definitions, Determinants, Theories and Link With

Optimum capital structure may be defined by Parmasivan & Subramanian (2009) as the capital structure or combination of debt and equity that leads to the maximum value of the firm. Optimum capital structure is the capital structure at which the Weighted Average Cost of Capital (WACC) is minimums and thereby the value of the firm is maximums.

23. Capital Structure Theory: What It Is in Financial Management

Suzanne Kvilhaug. In financial management, capital structure theory refers to a systematic approach to financing business activities through a combination of equities and liabilities. There are ...

24. Capital Structure and Financial Offering

The document discusses capital structure and financial structure. It defines capital structure as how a company finances its assets through a mix of equity and long-term debt. Financial structure includes both long-term and short-term funding sources. Key factors in designing a structure include leverage, cost of capital, control, flexibility, and solvency. Debt provides tax benefits but ...

25. Different Types of Legal Business Structures

Sole Proprietorship. In a sole proprietorship, the individual who founded the business remains the sole owner.They retain complete control over every aspect of the business. This is the easiest business structure for new or small business owners, as it is cost-effective and there are no other stakeholders to consider when making decisions.

26. 5 Ways To Raise Capital As A Small Business

The simplest option to secure capital for your business is through a basic business loan. ... For example, a few years ago, one of our clients raised \$3-plus million on the popular crowdfunding ...